9 Weeks to Better Options Trading: Risk Reversals

Veteran options trader Steve Smith breaks down the risk reversal.

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Editor's note: To help investors profitably navigate the options market, Minyanville has launched "9 Weeks to Better Options Trading," an educational series aimed at increasing trader understanding of the nuts and bolts of options, with an emphasis on real-world applications. In this series, veteran options trader Steve Smith will demystify a range of topics from options pricing to trading strategies to special situations like earnings reports and takeovers. Read the kick-off to the series here.

In previous articles in this series, we've looked at popular options trading strategies like calendar spreads, butterfly spreads, and condors, all of which use the simultaneous purchase and sale of puts or calls to create limited risk or partially hedged positions.

These traditional spreads allow you to reduce costs in exchange for capping gains. This week, we're getting more aggressive and drilling down into a strategy known as the risk reversal, which uses combinations of puts and calls to create a low-cost position that carries both unlimited risk and reward.

A risk reversal consists of being long (buying) an out-of-the-money call and being short (selling) an out-of-the money put, both with the same expiration date.

What makes the risk reversal different from most leveraged speculation or hedging strategies is that it aims to achieve a position with a very strong directional bias, but with a minimal capital outlay or possibly even a credit.

When constructing a risk-reversal position, the sale (purchase) of the put should offset the cost (credit) of the call.

A risk-reversal position simulates the behavior of a long (or short) position in the underlying shares. Therefore, it is sometimes called a synthetic position.

For example, if we wanted to make a bullish bet on IBM (IBM), with shares trading around $205, we could:

Sell the May $200 put for $3.20 a contract

Buy the May $210 call for $2.50 a contract

This gives us a $0.70 net credit ($3.20 - $2.50).

So, if IBM shares simply remain above $200, or do no worse than a 2.4% decline before the May expiration, the position will reap a $0.70 profit.

This risk reversal requires much less capital, even on a margin account, than buying underlying shares outright. The flip side is that if IBM only goes go up $210 at expiration, the profit will still only be $0.70, as both the put and call will expire worthless.

Of course, the ideal scenario would be the stock skyrocketing, as the call option will increase in value, while the put will be worth less -- creating unlimited profit potential. Note, however, that there is also significant downside risk if IBM's stock were to collapse. In that case, the value of the short put option would dramatically increase while the long call would be crushed.

Reducing the Risk Portion

As shown in the above example, because a pure risk reversal involves a naked short or uncovered sale of an option, it carries enormous downside risk. Again, this is no different than being long or short a stock, but my goal as an options trader is to gain the benefit of leverage but keep risk limited.

I do this by transforming the "naked" portion of the risk-reversal position into a standard vertical spread.

Sticking with the IBM example above, we could expand the position by going long the May $195 put, giving us the following combination:

Buy the May $195 put for $1.90 a contract

Sell the May $200 puts for $3.20 a contract

Buy the May $210 call for $2.50 a contract

This gives us a $1.30 net credit ($3.20 - $1.90) for the put spread, meaning the total position has now shifted to a $1.20 net debit. Note, we get $1.20 by subtracting the $1.30 net credit from the cost of the call, which is $2.50.

This puts the breakeven at expiration in the $199.30 to $211.20 range.

The breakeven points are calculated by adding (or subtracting) the net debit (or credit) to the risk-reversal strike prices. So when we received a $0.70 credit the, $200 put would be $0.70 in the money, making $199.30 the lower breakeven point. When we shift to a $1.20 net debit, it will take a rise above $1.20 above the $210 strike, or $211.20. Just remember these numbers are based on the expiration date, and profit and losses could change if the position is exited before expiration.

Using a spread on the put side caps the loss to $4.90 should disaster strike and IBM take a big dive below the $195 level. The upside, however, is still potentially unlimited as we remain outright long a call.
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I only employ this aggressive strategy when I feel there is a very, very attractive entry point that presents the potential for a strong counter move. At the same time, the put spread offers us a tight stop-loss level. The position is rarely held to expiration, so in case of an adverse price move, the short spread will not go to full value, so the maximum loss will rarely be incurred.

As an example, let's say IBM shares were at $195 at the end of April. The put spread would be in-the-money, and with three weeks until the May expiration, it would be worth approximately $2.50. Given it was sold for a $1.30 credit, the loss, if closed, would be $1.30, not the full $5, which is the width of the spread ($200 - $195).

So by turning that put into a spread, we can define downside risk and avoid a serious reversal of fortune.

For complete access to Steve Smith's trades in real-time, check out the OptionSmith portfolio, which returned 28% in 2011 vs 2% for the S&P 500. Click here for more details.

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